The chart above is the equity
curve of the Mandelbrot algorithmic trading program back-tested from March 30th
to July 28th 2015. The notional start equity was €90,000, and the
account balance at the end of the period was €135,720, allowing for
commissions. This gives a profit of 50.80% for the four-month period. A creditable
performance. Our job now is to ensure that the real-money accounts deliver that
outcome in the future. We will be using the optimised parameters for the
trading software that gave rise to the record above, but performance will be
carefully monitored to ensure that assumptions remain valid, and adjustments
may be made to the configuration of the software if that is deemed to be
necessary.
Each bar in the chart
represents the cumulative balance in the account on a daily basis. Gaps between
the bars illustrate those days on which no trading took place. They show mostly
weekends, as we do not hold positions from Friday to Monday, or indeed
overnight, but Mandelbrot is also programmed not to trade on days when sharp,
bi-directional volatility might be expected, as on US Non-Farm Payrolls day, or
when a significant monetary policy statement is issued, by such as the Fed or the
ECB.
Development of the OmiCron
Mandelbrot software has been guided by the principles outlined in the OmiCron
Forex Trading Manual, which is available from Amazon.
What is a draw-down?
Looked at together, the tops
of the bars, while generally proceeding in a satisfactory upward direction,
show what might be characterised as a serrated edge, such as would be found on
a saw. The falls in the amount of account equity from the peaks to the troughs
of this pattern are known as draw-downs. They indicate when a short-term loss,
or series of losses, interrupts the upward growth of the account.
The chart above shows the
small area that is highlighted by the dotted line box in the equity curve at
the top. This indicates the magnitudes of two draw-downs (a new, higher, peak is
necessary to complete the definition of the second draw-down, and that is only
visible on the top chart). Both of them result from a series of losses, and the
one on the right adds up to a total reduction of over €7800, or 5.9%, to the account
balance at the time. In absolute terms, this is not small change. The reason it
is so relatively large is because it occurs near the end of the period of
trading – Mandelbrot does all its work in percentage terms, so as the account
grows, so does the absolute value of any losing trades that take place (as well
as profitable ones, of course).
Draw-downs are an inescapable
fact of life in Foreign Exchange or in any other type of trading. The only
person who is known not to have had draw downs was one Bernard Madoff. In his
book, “The Man Who Stole $65
Billion”, Erin Arvedlund points out that this feature of Madoff’s hedge
fund returns was one of the things that made investigators suspicious. So
suspicious that they started the process that eventually wound up placing
Bernie behind bars for operating a massive Ponzi scheme.
In order to trade
successfully, the trader (or the algorithmic system that he or she uses), must
be able to sustain a loss. The only imperative is that it should be within the
risk tolerance of the system used.
In real-time, a draw-down
such as the larger of those shown above can be difficult to handle on a
psychological level. This particular one, as noted, involves no small amount of
account equity, and it has taken over a
week to play itself out.
That is why it is so
important to focus on the longer term outcome of trading. A narrow emphasis on
each day’s results is not good for peace of mind. Trades that result in nice
profits bring a warm glow, and even a feeling of elation, but sustaining a draw-down
like the one described, even though it is within the bounds of what is normal,
can be a harrowing experience unless the longer term is the focus.
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